Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Monday, November 8, 2010

Ron Paul on the Fed Again

I have to admit that I like listening to the little guy speak. My view of Ron Paul (and yes, I have read End the Fed, though I haven't had time to comment on it yet) is that he is a smart guy with good instincts and a good understanding of the events that have shaped monetary history in the U.S. and elsewhere. (This is unlike PK who, while also very smart, appears to have shaped his macroeconomic theory entirely on the apparent failure of a local babysitting cooperative).

Here is Ron Paul's attack on the Fed today: Fed Will Self-Destruct. I don't necessarily disagree with any of the points made in the written article (apart from the fact that Bernanke has never advocated 4% inflation). Some of the things he says in the video interview, however, seem rather strange.

With respect to our "deeply flawed monetary system" he appears to be concerned that one person (Bernanke) has the power to create $600B with the stroke of pen (out of thin air) and then spend it (foolishly).

Note: while the Fed is indeed able to create cash (or reserve balances) "out of thin air," under normal circumstances, the Fed is effectively prevented from spending this cash on anything other than U.S. government bonds. These bonds are also created "out of thin air" (they exist almost exclusively in book entry form). When the Fed purchases government bonds, it is really just swapping one form of air for another.

When phrased in this way, it becomes a little harder to see why a swap of Fed air for Treasury air should be inflationary (though note, his definition of inflation is money creation -- so of course he sees inflation everywhere, even though price-level inflation remains anemic).

Ron Paul is trained in Austrian economics. Austrians hew to the classical (Austrian) definition of inflation, which is the increase in money supply beyond what would be needed to keep up with growing demand.

And, we are seeing inflation, it just isn't in the CPI very much. But we're seeing inflation in asset prices (namely bonds and stocks), and raw materials prices.

Wonder Bread: The answer to your question is that it depends. The swap makes absolutely no difference in a liquidity trap scenario. For a simple exposition of this point, see my paper "The Hayashi-Prescott Hypothesis for Japan."

Prof J: I presume that you are not just defining inflation to be rising stock prices. In a model with real growth, the price of a Lucas tree will also rise (inflate), even when money is absent. And in any case, if inflation is indeed out there, how do you account for the very low yields on treasury debt?

You're right - I didn't mean that rising stock prices are evidence of inflation. Let me back up a little bit and give the broad strokes on how I think of this. I'll begin by defining two terms: monetary inflation and price inflation.

Monetary inflation is the increase of the money supply in excess of that needed to keep up with the money demand increase. Price inflation is the increase in the average price level of X, where X can be defined as any bundle of products.

Money inflation would then be superfluous money added to the economy by the money manufacturer. In the U.S., this is the Fed (sorry for being pedantic). The method of the open market operations has it that the money goes first to the primary trading partners (a few i-banks) and then moves down through the banking system and finally into the economy generally through lending by banks.

Monetary inflation causes price inflation in an order keeping with where banks lend first. If the banks lend primarily on mortgages, then one should see housing prices advance more quickly than they had been, and relative to other prices. Of course, that will have contagion effects into the intermediate goods markets like lumber, concrete, construction workers, etc.

Now, I account for the low yields on T-debt because of the demand by the Fed for the T-debt. As you point out, they are swapping T-debt for dollars, and they are buying more debt than Treasury is auctioning. But look at the steepness of the yield curve:

http://online.wsj.com/mdc/public/page/mdc_bonds.html?refresh=on

Is that steepness just a maturity risk premium? Some, sure. But I think it also can be argued to be an inflation premium.

Second, as you know (and I point out) the banks have to push the money into the economy. A fast look at non-borrowed reserves indicates that banks are not lending very much of that money the Fed had earlier deposited with them. I don't know if the banks aren't willing to supply it, or if businesses aren't demanding it, but it is sitting in the banks - not being lent into the economy.

Prof J, I'm impressed. First time I've seen you lay out an explanation of any length. Some of it escapes me (but that is to be expected).

David, what would be wrong with imagining "two economies," and not much "trickle-down," and plenty of money in the one economy leading to asset-price inflation, and not much money in the other helping to hold the CPI down?

You say: Monetary inflation is the increase of the money supply in excess of that needed to keep up with the money demand increase. Price inflation is the increase in the average price level of X, where X can be defined as any bundle of products.

These two definitions appear equivalent to me. Explain to me why they are not.

Wrt to the yield curve, you'll note that it has in fact flattened out (relative to one year ago) in the 1-5 year range. This must be very puzzling for Ron Paul, no?

The Arthurian: There is nothing "wrong" in thinking that way, though such thinking glosses over a lot of important details that may lead to different conclusions. Is the "plenty of money" in the one economy a temporary or permanent injection? Is the new money used to buy treasuries or is it injected by way of helicopter drops? Etc. etc.

In reverse order: the yield curve has indeed flattened some, but remains steep. I'm no Ron Paul apologist, so I don't know if it's a problem for him. I do think bond market signals should be interpreted with great care right now because of the various forces pushing bond prices abnormally high. That means I also wouldn't point with certainty to the steepness of the yield curve and say for sure that it is an inflation premium.

I want to ask for some clarification on why you think monetary and price inflation are equivalent. Is it because you think money is neutral (I don't know if you think this or not) or for some other reason?

Finally, I think there is some mixed evidence coming from producer prices for inflation. I looked at PPI from the St. Louis Fed for a variety of items, but it seems energy is the biggest mover there. Also, there are articles like this: http://online.wsj.com/article/SB10001424052748704635704575604443663385672.html popping up.

Note I say this is mixed evidence because, for example, the increase in cotton prices has more to do with trade barriers with Brazil than with inflation.

To reiterate: You say: Monetary inflation is the increase of the money supply in excess of that needed to keep up with the money demand increase. Price inflation is the increase in the average price level of X, where X can be defined as any bundle of products.

Actually, that is sort of what I was thinking when I asked about money neutrality.

Let's go with MV = PQ. My point is the M expansion causes the P increases. But, M increases don't show up in P necessarily. I think of this by expanding the right hand side and making is thus: p1q1+p2q2+p3q3+...+pNqN where N is the number of goods/services in the economy. The typical numbers I see being tracked are pFqF + pIqI + pRqR where F is final goods (CPI) I is intermediate goods (PPI) and R is raw materials (also a PPI component).

So this is what I'm saying - increasing money supply shows up not just (or even necessarily) in final goods prices, but in producers' goods prices. The aggregation of prices and quantities in the equation is deceptive, I think.

Most certainly the prices must flow through to final goods at some point. It is not clear that this should happen immediately though. What seems to have been happening is that businesses have been letting their shareholders bear the burden of rising factors prices in the form of lower profit margins, and are now starting to shift the burden to customers. Admittedly, my data on this is weak, as I'm only getting it from articles like this one: http://online.wsj.com/article/SB10001424052748704506404575592313664715360.html

Again, I don't want to say that there is necessarily inflation pressure in the system since banks do seem to be hoarding (why I don't know) much of the "stimulus" money being produced by the Fed. If the money is being hoarded, we really shouldn't see any inflation in goods prices, but we might still see reactions in asset prices (like bonds) because of so-called announcement effects.

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